China: Which Direction for the Yuan?

I’ve recently had some conversations on the idea that China is intentionally weakening their currency, the yuan (aka the RMB), in an effort to put some support under economic growth that’s slowing down. It’s an interesting argument, but my personal take is that while China’s happy to accrue the benefits of a weaker currency, they’re probably not intentionally trying to depreciate it given the impact such actions could have on capital flows. It’s understandable why China would welcome some depreciation in the yuan; they’ve borne the brunt of real (about 38%) and nominal (about 27%) currency appreciation in the last nine years. And that’s impacted their export competitiveness.

A stronger currency (in real terms) is a headwind for China’s exporters, making Chinese goods relatively more expensive to their trading partners. But it acts as an incentive for carry trades, especially as China’s onshore interest rates are higher than U.S. and Hong Kong interest rates. In effect, it gives incentives to borrow at next to nothing in U.S or HK Dollars and invest into RMB assets (primarily fixed income securities) to not just get a positive interest rate carry, but also gain from an appreciation in the value of the RMB. One reason why China’s central bank, the People’s Bank of China, widened its currency band recently was to encourage more two-sided moves in the value of its currency to flush out such carry inflows.

Assuming the above is true, the next logical question is whether the RMB should actually appreciate structurally and fundamentally from here on. To me, the answer is probably ‘no.’ China’s current-account surplus for 2014 is likely to be less than 1.5% of GDP (it was upwards of 9% in 2007). That’s another way of saying their current-account surplus is ‘finely balanced.’ Gross foreign direct investment (FDI) inflows are still running at around US$120 billion per year, but Chinese companies are also investing a great deal into overseas markets, so the net FDI number is just about US$40 billion annually. Given the current account and FDI issues at hand, I don’t see a great reason for the yuan to appreciate meaningfully from here on, based on these drivers.

So, the case for RMB appreciation would rest on one or more of the following situations playing out:

Overseas investors start investing into Chinese fixed assets significantly (I say that’s unlikely given the decline in private-sector returns in the last two to three years)

Demographic changes take China down the path that Korea and Japan have trod – i.e., high savings, low spending, and persistently low relative inflation that causes persistent currency appreciation

Increased allocation to the yuan in global reserves (I’m already hearing that some central banks have started allocating reserves to China; a 5% shift on a portfolio basis implies an inflow of US$400 billion, as Global FX Reserves excluding China’s are in the vicinity of US$8 trillion)

China dismantles its QFII (qualified foreign institutional investor) scheme and allows free access to its capital markets for global investors. That would make China onshore a mainstream equity market (inclusion in global indices), attracting foreign inflows and cause the currency to appreciate over the following 12 months

Counterbalancing the above will be increased globalization of Chinese domestic savings (which are currently trapped almost completely within onshore Chinese investment products) and greater obligation to service the FDI and debt inflows that China has accumulated in the past, causing outflows from RMB. It’ll be an interesting battle between these opposing forces in coming months. On the whole, we think the scales are finely balanced, replacing the earlier environment of one-sided currency moves to a more balanced one, with more pronounced changes in either direction.

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The information in this article has been derived from sources believed to be accurate as of May 2014. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity.

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